Alpha Natural Resources Ratings Cut: Why We Were Right On Coal Stocks

In our previous article on coal stocks, we advised investors to target those players that were more exposed to thermal coal rather than those whose main source of revenue was metallurgical coal. This is because we feel that the thermal coal industry has reached an inflection point, as a result of rebounding natural gas prices, increasing exports and production cuts. Consequently, we advised investors to stay away from metallurgical coal players like Alpha Natural Resources (ANR) and Walter Energy (NYSE:WLT). The recent ratings cut of ANR by S&P substantiates our cautious approach towards the company. We feel that there are far better player than ANR to put money in, like CONSOL Energy (NYSE:CNX) and Peabody Energy Corporation (BTU), if an investor wants to aim a rebound in the coal industry.

Ratings Cut

According to a recent press release, Standard and Poor's Ratings Service has lowered its ratings on Alpha Natural Resources from "BB-"to "B+." According to the credit analyst, Megan Johnston, "The downgrade reflects our expectation that Alpha's 2012 and 2013 EBITDA will be much lower than what was previously anticipated because of a sharp cyclical downturn in domestic coal demand."

The ratings agency attributed fewer production disruptions and depressed demand in China and the Eurozone for the decline in metallurgical coal prices, which hurt ANR badly. The company also suffered from warmer-than-normal winters and the coal-to-gas switching trend, which hurt its thermal coal operations in the Central Appalachia (OTCQB:CAPP) basin.

S&P expects Alpha Natural Resources' EBITDA to be in the range of $600-700 million and $500-600 million in 2013, which will lead to its leverage ratio being 6x and 8x, respectively. Its funds from operations (FFO) are also expected to drop below 10%.

However, one of the positive aspects about the company is its strong liquidity position. The company's liquidity sources (cash and the available revolving credit facility of $1 billion) are expected to be more than the uses, even if EBIDA drops by 30%.

Investment Advice

We continue to recommend other coal players over Alpha Natural Resources, though we are not very bullish about the coal sector in the near-term. CONSOL Energy Inc. is the best option considering the fact that its natural gas exposure makes it relatively safer from the natural gas substitution trend. In addition, its high thermal coal exposure (driving 63% of its revenue) makes it a good investment in the near-term.

Another good investment could be Peabody Energy Corp., even though its recent quarter results were a major disappointment. The company does not have any noteworthy debt maturities till 2015. Moreover, its most recent quarter-end cash balance of $489 million and operating cash flow of $380 million (from which it has managed to buy back $242 million of below-par bonds and $100 million of shares), show the company's healthy liquidity position.

Despite having a reasonable thermal coal exposure, we are neutral-rated on Arch Coal Inc. (ACI), as a result of its high market leverage and weak balance sheet. The following table summarizes the crucial valuation metrics for the major coal players under our coverage.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Basic Materials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.